Weighing the Week Ahead: Will the Fed’s Experiment End Badly?

Put together these ingredients: The biggest weekly market decline in two years, the winding down of earnings season, and a light week for economic data. The result? Financial TV producers will be seeking experts to explain whether we are starting a major correction. Analyzing the Fed will be a favorite theme.

Unless and until we get a bit of a rebound in stocks, I expect a focus on this question:

Will it all end badly?

Prior Theme Recap

In my pre-vacation WTWA I expected that attention would turn to corporate earnings. That was accurate. I also expected that earnings would probably surprise to the upside. So far, so good. I noted that the market had digested a fair amount of bad news. True enough. Finally, I asked whether this might reignite the stock rally. In my final thought, I emphasized the need for right-sizing positions in the face of risk.

The upside breakout in stocks did not occur, and the focus has shifted back to what might be wrong in the world.

Naturally we would all like to know the direction of the market in advance. Good luck with that! Second best is planning what to look for and how to react. That is the purpose of considering possible themes for the week ahead.

San Francisco Appearance

I have agreed to speak at the San Francisco Money Show in three weeks. Here is more information. I am working on some special themes. We will have some fun and also identify some good investment ideas. I look forward to meeting some readers in person.

This Week’s Theme

The stock market finally broke from the recent quiescence. Doug Short always captures the week in a single great chart. Things were quiet for my return from vacation – at least until Thursday!

What was the cause of the decline? Let us start with what does not make sense, including most of the explanations offered. We saw the typical pundit parade both on TV and from major print and web media. Anyone who had a bearish theme over the last year or so got some exposure. I watch a wide variety of sources, but some of these experts came out of nowhere. Each has a method that has “always” worked when three or four elements happens together. You cannot find the experts with a web search, so there is no ability to check their track records. That does not prevent writers needing a story from featuring the scariest news.

There was some fresh news on Thursday, perhaps enough to spook some nervous traders. First, the employment cost index was up 0.7% for the quarter. Put aside the idea that many have argued the need for better wage gains. This single reading (2% year-over-year) was trumpeted as news that Yellen was wrong about labor market slack. Higher interest rates would be coming soon, etc. This was not confirmed by hourly wage data on Friday, but the damage was done. Second, the sanctions against Russia are ratcheting higher. For financial markets, the question is how this affects trade and the European economy.

I expect more of the same worries to be featured at the start of next week’s trading. Here is a simple guide to the negative side:

The issue. In the most recent CNBC survey of “Wall Street Pros” more than 1/3 of respondents said that the Fed’s current policies would “end badly” and another ¼ thought the outcome was a toss-up. Confirming this, about half of those responding believe that the Fed is too accommodative. The survey results are consistent with the daily commentary from many sources. (See Steve Liesman report and also the full results).

The combination of policy issues and weaker stocks has bears out in force. See Rob Copeland’s WSJ piece or simply turn to the lead page at your favorite finance site. The first sign of selling is cited as confirmation of a wide range of theories about valuation, divergences, market cycles, and assorted indicators.

There are also some important counter-arguments:

Fed forward guidance can have a real economic effect, perhaps more powerful than QE. Mark Thoma has an excellent explanation that shows the importance of Fed credibility about the future course of short-term rates.

When we analyze the data, we find that almost three-fourth of the time when rates were rising stocks tended to rise as well. When we looked at the conditions during these periods of rising stocks and rates, we found that the 10-year bond yield averaged 5.11 percent, the price-earnings ratio of the S&P 500 averaged about 15, and inflation as measured by the consumer price index was more than 4 percent. The average S&P 500 increase during these periods was almost 21 percent.

As usual, I have a few thoughts to help in sorting through these diverse viewpoints. First, let us do our regular update of the last week’s news and data. Readers, especially those new to this series, will benefit from reading the background information.

Last Week’s Data

Each week I break down events into good and bad. Often there is “ugly” and on rare occasion something really good. My working definition of “good” has two components:

The news is market-friendly. Our personal policy preferences are not relevant for this test. And especially – no politics.

It is better than expectations.

The Good

Most of the important news last week was very good.

ISM Manufacturing hit a three-year high. Bespoke has discussion as well as the chart below. Scott Grannis also looks at the index showing the relationship to GDP.

Earnings reports continued to be strong. FactSet reports a terrific 74% earnings beat rate and 65% beats on sales. The year-over-year growth is 7.5%. Zacks shows even stronger growth. The confirmation of earnings growth also supports the forward earnings estimates. I know that many are skeptical of this approach, but perhaps they should look at the data (also from FactSet).

Auto sales remain strong. Bespoke updates the Ford F-Series truck sales, a useful proxy for construction and small business. The level is the best since 2006, despite the impending changeover to a new model.

The PCE index shows only 1.6% year-over-year growth. This is the Fed’s preferred measure of inflation and it is well below the 2% target. See Doug Short for full analysis and charts.

Conference Board consumer confidence was strong. The data help us to understand job creation, complementing the information about job losses that we get from the initial claims series. Ed Yardeni explains the relationship and provides this chart:

Employment growth remained strong. The report was mixed versus expectations – a slight miss on the net change in payroll jobs and an uptick in unemployment, but better labor force participation and a reversal of the part-time job worries. The overall story is one of continuing modest growth, but not yet close to the goal line. It seems to provide support for Fed Chair Yellen’s viewpoint (See Jason Lange at Reuters) that there remains some slack in the labor market. (See Phil Izzo’s WSJ update).

Q2 GDP showed 4% growth, handily beating expectations. Putting the first and second quarter together suggests a continuation of modest growth similar to the past two years. There is a continuing question about what can drive a higher level of economic expansion. James Hamilton has the thorough examination we would expect from him, with the hopeful note that this could be the first in a string of better reports. Here is his chart of the contributors to growth:

Consumers are borrowing again. The end of deleveraging is a market-friendly development. (See The Economist).

The Bad

There was also some negative news.

Technical damage. With a near-term focus on trading, I am especially interested in what I can learn from Charles Kirk. His weekly chart show is members-only, but the cost is minor compared to the value. Without giving away his story, let’s just say that Charles is wary and watching possible bearish setups. Even if you are a long-term investor, it helps to know what levels are viewed as crucial.

Congress goes on recess.Some would see this as good news. What’s another five weeks after the most unproductive legislative stretch in history? A few years ago it was popular for market participants to view Washington gridlock as good. This may have been based upon earlier eras when there was a partisan split between the Executive and Legislative branches. This often led to bipartisan compromise and moderate policies. Things are different now. From The Hill:

A measure of members’ ideologies developed by political scientists Howard Rosenthal and Keith Poole finds that Congress is more polarized now than at any time since the end of Reconstruction in the 19th century.

Their data show the number of centrist members in both parties has fallen from around 40 percent in the early 1980s to under 10 percent today.

“The effect is rather complete policy paralysis,” said Rosenthal, a professor at New York University.

“They don’t talk because they’re just so ideologically opposed,” he said.

Absent negotiations on legislation, both sides now seem to take increasing delight in lobbing blame at each other.

Argentina defaulted on its debt. Or maybe not. It depends upon your source. We’ll know soon whether holders of credit default swaps collect. For the rest of us, it does not seem to be a question of solvency. (See Quartz).

Pending home sales were weak. Prices are also soft and entering a seasonally weak period. (See Calculated risk here and here).

China housing pricesdropped 0.8%, the third straight month of decline. The pace is accelerating. (SeeWSJ).

There are continuing conflicts, violence and death competing for our attention. The Ebola crisis, cited a few weeks, ago has entered a new stage. The disease has spread to Lagos, a densely populated city of 21 million and a center for travel. Gwynn Guilford at Quartz has a detailed report.

The Silver Bullet

I occasionally give the Silver Bullet award to someone who takes up an unpopular or thankless cause, doing the real work to demonstrate the facts. Think of The Lone Ranger.

No award this week. Maybe before next week someone will point out the obvious problems with this chart:

Quant Corner

Whether a trader or an investor, you need to understand risk. I monitor many quantitative reports and highlight the best methods in this weekly update. For more information on each source, check here.

Recent Expert Commentary on Recession Odds and Market Trends

Doug Short: An update of the regular ECRI analysis with a good history, commentary, detailed analysis and charts. If you are still listening to the ECRI (2 ½ years after their recession call), you should be reading this carefully. Doug includes the most recent ECRI discussion, which has been consistently bearish, including the blown call on the recession. Doug Short has a new version of his “Big Four” chart. It has now been updated for real personal income and the employment data.

Bob Dieli does a monthly update (subscription required) after the employment report and also a monthly overview analysis. He follows many concurrent indicators to supplement our featured “C Score.” One of his conclusions is whether a month is “recession eligible.” His analysis shows that none of the next nine months could qualify. I respect this because Bob (whose career has been with banks and private clients) has been far more accurate than the high-profile TV pundits.

RecessionAlert: A variety of strong quantitative indicators for both economic and market analysis. Dwaine’s “liquidity crunch” signal played out as projected. His market timing method is “armed for the next possible long signal.”

Nikki Kahn at The Washington Post has a great feature article on FRED, “every wonk’s secret weapon.” Readers of our Quant Corner have all seen charts from FRED. In my first uses of this great resource I was still visiting via a dial-up modem! FRED has changed both in the exhaustive coverage of data and the ease of use.

A companion article shows some favorite charts from leading economic observers. They are all interesting, but I especially liked this one from Cardiff Garcia of FT Alphaville. It shows the trends in manufacturing and construction employment, converging before 2007, but sluggish now. Very interesting, and not obvious from most discussions of employment.

Wholesale inventories (F). More June data with implications for GDP revisions.

Earnings news will have some effect, with about 25% of the S&P 500 still to report. Events in any of the world hot spots will also command attention.

With the FOMC meeting behind us, the Fed participants will be free to hit the speaking circuit. Some believe that the message is orchestrated. That was true of the Greenspan Fed, but less so now. The modern Fed has plenty of transparency, including the divergent views of members. Surprisingly, I do not see anything on the calendar. We shall see.

How to Use the Weekly Data Updates

In the WTWA series I try to share what I am thinking as I prepare for the coming week. I write each post as if I were speaking directly to one of my clients. Each client is different, so I have five different programs ranging from very conservative bond ladders to very aggressive trading programs. It is not a “one size fits all” approach.

To get the maximum benefit from my updates you need to have a self-assessment of your objectives. Are you most interested in preserving wealth? Or like most of us, do you still need to create wealth? How much risk is right for your temperament and circumstances?

My weekly insights often suggest a different course of action depending upon your objectives and time frames. They also accurately describe what I am doing in the programs I manage.

Insight for Traders

Felix has remained neutral with confidence greatly reduced. Uncertainty remains high – typical for a trading range market. This week we were only partially invested at first, but fully invested by week’s end. This is a bit deceptive, since one of the positions is in bonds and only one is in US equities. Felix remains cautious.

Brett Steenbarger notes the recent weakness in junk bonds, an indicator of reduced market tolerance for risk. If Felix could read, he would certainly follow Dr. Brett. If you are a trader, you should, too.

Adam Grimes warns that trading is a lot harder than you think. More of it is random and unpredictable. Here is a meaningful quote:

There are things that work in trading, but they probably don’t work as well as you’d like to think. A corollary to that is: most people lie. The guy you are talking to in that trading room who tells you how he has made money every day for the past 5 years buying a candlestick reversal off of a moving average? He’s almost certainly lying. The guy trying to sell you the trading course that promises to reveal “insider secrets” and how to make $33,871 in 30 days? He is also lying. The guy calling out trades every day in stocks? He’s probably trading 100 shares.

You can sign up for Felix’s weekly ratings updates via email to etf at newarc dot com.

Insight for Investors

I review the themes here each week and refresh when needed. For investors, as we would expect, the key ideas may stay on the list longer than the updates for traders. The current “actionable investment advice” is summarized here. In addition, be sure to read this week’s final thought.

The market has finally provided some volatility. This is attractive for long-term investors who have a good shopping list. We may some position changes and also added to our Enhanced Yield positions (dividend stocks versus near-term short call options). These new positions are best established on down days.

Here are some key themes and the best investment posts we saw last week.

It is a great time to be an individual investor. Tadas Viskanta, our go-to source for what is happening in financial markets, wrote on this theme thirty months ago. His update at The Big Picture reviews how the original concept played out. Many have joined his conclusion, highlighting lower costs and greater opportunities. This is a post that deserves a careful read.

Beware the “popular stocks” says Patrick O’Shaughnessy. He suggest that value investors look elsewhere, and provides some good examples.

Jonathan R. Laing, in a Barron’s cover story, asks Can ETFs Be Derailed? He analyzes some problems with intra-day liquidity. His informative look at the relationship between the ETF price and underlying shares is an important topic for ETF investors. Felix and I have noticed some apparent large discrepancies, and we stick to the high-volume, high-liquidity funds.

Beware of reading entertainment and confusing it with investment advice. Noah Smith provides some great examples, emphasizing those who mix in some politics to gain extra attention. He reviews predictions from some popular sources. There is no good way to summarize this analysis of the clash of the self-taught Austrian economists, but you will benefit from reading it.

If you are worried about possible market declines, you have plenty of company. This is one of the problems where we can help. It is possible to get reasonable returns while controlling risk. You can get our report package with a simple email request to main at newarc dot com. Also check out our recent recommendations in our new investor resource page — a starting point for the long-term investor. (Comments and suggestions welcome. I am trying to be helpful and I love and use feedback).

Final Thought

General investment commentary seems to get even worse at times of market stress. The competition for readers or viewers gets even more intense. Have you noticed that extreme opinions become the norm? The Fed story has been the popular recent example. Investors can be better consumers of this information with a little help from two insiders, Josh Brown and Jeff Macke. During my vacation I finished reading their entertaining and informative book — Clash of the Financial Pundits: How the Media Influences Your Investment Decisions for Better or Worse. I plan to do a complete review, but it is especially timely right now. As you watch or read the news next week, you should realize the pressure on pundits to be bold, dramatic, and confident – even when their forecasts are a bit shaky. The financial incentives range from selling products to building a big reputation. Their analysis of these forces is supported with some compelling evidence from both history and interviews. Reading this book is inoculation against hype, and it is also a lot of fun. As so often happens, if you merely looked at the news last week, you would never have predicted the market result. Economic and earnings fundamentals remain sound. Recession risk is low. I expect things to stabilize, but I am not surprised by increased volatility. The story of the change in Fed policy will play out over the next two years, with plenty of chances for both traders and investors.